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How Do Mutual Fund Distributions Work?

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How Do Mutual Fund Distributions Work? Investor Knowledge + 20 Minutes = Confident Investing KNOWLEDGE How do mutual fund distributions work? This guide will help provide you with an understanding of different types of mutual fund distributions and how they can impact investments. Distributions paid by mutual funds represent earnings generated by different types of investments held in the fund. As these investments earn income or are sold by the fund, the earnings are distributed in various ways. Depending on the source of the earnings, mutual fund distributions can have different tax implications and should be clearly understood for efficient tax planning Contents Fundamentals of distributions 2 Types of Distributions 3 Impact of Distributions 5 ROC Distributions 11 Corporate Class Funds 13 Other Considerations 14 How do mutual fund distributions work? | June 2019 | Page 1 Distribution Fundamentals Q: What is a distribution? Q: How are distributions calculated? A mutual fund distribution represents the earnings of Distributions are allocated to unitholders in proportion to a fund being passed on to the individual investor or the number of units they hold on a specific date, known as unitholder of the fund. the “record date”. Example: If you held 100 mutual fund units on the record Q: How often are distributions made? date, and the distribution was $0.50 per unit, you would receive a taxable distribution of $50. The frequency varies by the specific fund – distributions can be paid monthly, quarterly, or annually. Q: Are distributions made for a set amount? While some mutual funds have a target or fixed Q: Why do mutual funds make distributions? distribution, the sustainability of the fixed distribution is based on market performance. As a result, a fund may Earnings retained by a mutual fund are generally subject change the distribution amount without notice. to tax at the highest marginal rate. Distributions received by individual investors are taxed at their own marginal tax rates, which may be lower than the rate applicable to the fund. Note The different types of distributions that are discussed in this guide include interest income, Canadian dividend income, capital gains, return of capital and foreign income. Fundamentals How do mutual fund distributions work? | June 2019 | Page 2 Types of Distributions What are the different types of distributions? Type of distribution Definition Taxation Mutual fund type Interest income Occurs when the fund • Fully taxable at the • Fixed Income earns income on debt same marginal tax rate • Balanced Funds securities (e.g. treasury as ordinary income • Fund of Funds bills and bonds). • Reported on your T3 • TD Cash Flow Series tax slip (Relevé 16 • TD Monthly Fixed in Quebec) Pay Solutions Canadian dividend Received when a fund • Generally eligible for • Canadian equities income invests in shares of federal and provincial • Balanced Funds public companies that tax credits • Fund of Funds pay dividends. • Tax rates vary by • TD Cash Flow Series province • TD Monthly Fixed • Reported on your T3 Pay Solutions tax slip (Relevé 16 in Quebec) Capital Gains Generated when the • Only 50% of the capital • Canadian equities trading activity within gain is taxable to • U.S. Equities a fund results in an unitholders • Emerging Markets overall gain. • Reported on your T3 Equities tax slip (Relevé 16 • Balanced Funds in Quebec) • Fund of Funds • TD Cash Flow Series • TD Monthly Fixed Pay Solutions Foreign non-business Occurs when the fund • Fully taxable at the • U.S. Equities income receives dividends, same marginal tax rate • Emerging Markets interest or other types of as ordinary income Equities distributions from foreign • Reported on your T3 • Balanced Funds investments. tax slip (Relevé 16 • Fund of Funds in Quebec) • TD Cash Flow Series • TD Monthly Fixed Pay Solutions Return of Capital (ROC) Generated when an Not taxable since it’s a • TD Cash Flow Series investor’s original return of investor’s own • TD Monthly Fixed investment amount, or invested capital (which Pay Solutions capital, being returned to has already been subject them by a mutual fund. to taxation). Reduces the Typically occurs when ACB of the fund which the fund’s objective is to typically results in bigger generate regular monthly capital gain (or smaller distributions. capital loss) when the units are sold. How do mutual fund distributions work? | June 2019 | Page 3 Types of Distributions How Different Distributions are Taxed: The example below shows the after tax value of $100 for the different types of mutual fund distributions: Interest Dividends $66 $34 $50 GIC $50 Capital Gains Return of Capital $75 $25 Non- $100 Taxable* *Example shown for illustrative purposes only. Tax rate assumptions (Ontario): 49.53% marginal income tax rate; 33.82% dividend income marginal tax rate; 24.77% capital gains marginal tax rate. Percentages have been rounded. As long as the adjusted cost base of the investment is greater than zero. Capital gains taxes may be payable when the units of a fund are sold or to some extent when their adjusted cost base goes below zero. Return of capital (ROC) distributions do not constitute part of a fund’s rate of return or yield. ROC reduces the adjusted cost base of the units to which it relates. ROC is not considered taxable income as long as the adjusted cost base of the investment is greater than zero. Capital gains taxes that may be deferred when ROC distributions are received, will be payable when the units of the fund are sold or when their adjusted cost base goes below zero. How do mutual fund distributions work? | June 2019 | Page 4 Impact of Distributions How do distributions impact mutual funds? Distributions can affect your mutual fund in different ways. They can impact the Net Asset Value (NAV) or price of your funds and, if re-invested, your ACB and book value. Net Asset Value (NAV) represents the price of How do distributions affect the price of a fund? a mutual fund. The NAV per share represents the During the year, as interest, dividend income and mutual fund’s assets less its liabilities and will change capital gains are accumulated in the fund, the due to fluctuations of the market value of your mutual NAV will increase. If a distribution is made, the NAV fund’s investments. A fund’s NAV is calculated daily per unit drops as the fund holds fewer assets after using the price of the securities in the mutual fund at the distribution. the market close. Note Taxable income in an Registered Plan, such as a Retirement Savings Plan (RRSP) or a Tax Free Savings Account (TFSA) is treated differently. An RRSP defers the tax payable on investment income for as long as the funds remain registered. Investment income in a TFSA is tax free. Reinvested distributions do not count as contributions and therefore do not affect the contribution room for either account type DistributionsHow do mutual fund distributions work? | June 2019 | Page 5 Impact of Distributions Impact of distributions: 2 ways to receive a distribution 100 units purchased at $10/unit $1000 The following example shows the difference between receiving the distribution in cash versus being reinvested to purchase Initial Purchase additional units • NAV increases to $11 due to income earned $50.00 ($11/unit x 100 = $1,100 market value) Distribution • NAV increase triggers a distribution (Fund distributes • Distribution reduces the NAV/unit to $10.50 (100 units x $10.50 = $1050) $0.50/unit each year) Final Portfolio Value Option 1: Cash Option 2: Re-invest The $50 distribution gets paid out in cash, The $50 distribution gets reinvested to purchase the units you hold remain the same additional units at the current NAV of $10.50. This increases your holdings by 4.7619 units $50.00 / $10.50= 4.7619 units 100 104.7619 Unit Holdings Unit Holdings $50 $50 Received in Cash Reinvested Distribution $1050 $1100 Total Value of Portfolio Total Value of Portfolio $1100 (Cash + Portfolio Value) For illustrative purposes only. How do mutual fund distributions work? | June 2019 | Page 6 Impact of Distributions How distributions affect your book value • Book value is the amount you paid for your investments, while market value is the amount your investments are worth on a given day • The market value of your portfolio fluctuates due to changes in the NAV of your mutual fund(s) • Reinvested distributions are treated as new purchases and therefore impact your book value • Cash distributions do not affect your book value. Book Value Purchase $10/unit x 100 = $1,000 Distributions are set up to 100 units purchased at $10/unit be reinvested: Follow-up purchase: $12/unit x 100 = $1,200 100 units purchased at $12/unit Reinvested Distribution: 100 units x $0.50 = $50.00 Fund distributes $0.50/unit each year New Book Value: $1,000 + $1,200 + $50 = $2,250 For illustrative purposes only. Note Book value and market value cannot be used to calculate performance. Instead, you need to compare the amount invested with the current market value. Here’s how: • Market value of investment = $1,100 • Amount invested = $1,000 = [(Current market value – Amount invested)/Amount Invested] x 100 = [($1,100 - $1,000) / $1,000] x 100 = ($100/ $1000) x 100 = 0.1 x 100 • Fund Performance = 10.00% How do mutual fund distributions work? | June 2019 | Page 7 Impact of Distributions What happens when your book value is higher than your market value after a distribution? If there is market volatility close to the time a distribution is issued, it is possible that the market value of your investments may be lower than your book value, even after the distribution. It’s important to remember that, just like a capital gain, a capital loss is not realized until you redeem your units.
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